Removing Accommodation

Summary

Think of the increases in the fed funds rate not as the beginning of an interest rate tightening cycle, but as the beginning of a process to remove a substantial amount of monetary policy accommodation.

This “removal of accommodation” cycle still has a ways to go. The real (inflation-adjusted) effective fed funds rate is still negative, and accommodative, and likely will remain so until the nominal rate reaches 2%. The Fed’s latest dot plot suggests that won’t happen until year-end 2018.

At least three challenges could complicate the Fed’s efforts to remove accommodation. First, crucial details on how the Fed will shrink its $4.5 trillion balance sheet remain unresolved. Second, policymakers face the ever-present threat of a financial, political or geopolitical event somewhere in the world that disrupts trade flows, risk appetite, financial markets and exchange rates. Third, the composition of the Fed Board of Governors is likely to change significantly by next year.

It’s now officially a “rate hike cycle,” said the pundits after the Federal Reserve’s March increase in the federal funds rate – the second hike in three months, and the third overall since December 2015 (which was the first increase in the policy rate in nine and a half years!). Whatever the talking heads may call it, it is more useful for investors to think of these increases in the fed funds rate not as the beginning of an interest rate tightening cycle in the U.S., but rather as the beginning of a process to remove what is at present ‒ and will for some time continue to be ‒ a substantial amount of monetary policy accommodation sloshing through the global financial system.

The extent of that accommodation can be quantified in a few ways. In the U.S., the effective federal funds rate (a nominal interest rate), at roughly 0.9% following the March hike, still falls well short of the Fed’s preferred measure of inflation (Personal Consumption Expenditures or PCE), which is running at a headline rate of 1.9%. In other words, the real (inflation-adjusted) effective fed funds rate remains negative, and accommodative. Fed officials appear to be in broad agreement that r*, the equilibrium (neither accommodative nor restrictive) neutral real policy rate consistent with full employment and the Fed’s 2% PCE inflation target, is at present around 0%. (At PIMCO, we recognized early on that the neutral rate had moved lower than its historical average; we introduced this concept of The New Neutral in 2014.) This 0% rate for r* would imply that the (nominal) fed funds policy rate will remain – by definition – “accommodative” until it reaches 2%.

The forward-looking Taylor rule illustrates this concept – see Figure 1. The Taylor rule is an interest rate forecasting model that helps guide how a central bank policy rate should respond to actual versus targeted levels of inflation and unemployment; a forward-looking Taylor rule is one variation that emphasizes longer-term inflation forecasts and tends to imply a slower, more gradual tightening process. Still, with r* at 0%, the theoretical forward-looking Taylor rule policy rate remains well above the actual fed funds policy rate (even after the so-called rate hike cycle has begun) – and the gap between them is accommodation.

And when might the policy rate reach 2%? The Fed, via the median of the projections depicted in the most recent dot plot, doesn’t forecast getting the fed funds rate to 2% until year-end 2018. So this “removal of accommodation” cycle – which I admit is a mouthful of nine syllables, so how about calling it “ROA” instead – still has a ways to go. Initial market reaction to the policy rate hikes – with stocks higher, credit spreads tighter and the dollar weaker – was consistent with this interpretation that the Fed intends a gradual path toward normalization. Call it a dovish ROA.

The policy path: if only it were that simple

So should investors simply tune out all the talking-head Fed chatter until the real fed funds rate climbs back to zero and a tightening cycle actually begins sometime late next year? As tempting as that sounds, there are at least three possible complications that may well present challenges to the Fed (and thus markets) as it tries to execute a removal of accommodation.

First of all, the Fed has left unresolved – and appears to be undecided about – a number of crucial details on how it will seek to shrink its $4.5 trillion balance sheet. These questions include, how will this process proceed? starting when? at what pace? over what time frame? to what destination? Needless to say, if (as Fed officials believe, and I agree) the three asset purchase or “quantitative easing” (QE) programs the Fed undertook in the months and years following the global financial crisis lowered the term premium on long-maturity U.S. Treasuries and mortgages, then the unwinding of this portfolio likely will put upward pressure on term premia and thus long-term bond yields and mortgage rates. Remember that while QE 3 ended in October 2014, the Fed has remained a very big player in both the Treasury market and the mortgage-backed securities (MBS) market as it has been buying bonds to maintain the balance sheet’s size in the face of maturing issues and MBS prepayments.

A second risk to a “rosy” ROA scenario is the ever-present threat of a financial, political or geopolitical event somewhere in the world that disrupts trade flows, risk appetite, financial markets and exchange rates. The Fed – appropriately – will factor in global developments as it decides meeting by meeting whether to remove additional accommodation. As we saw in the summer of 2015 with the June sell-off in China equities and the August devaluation of the Chinese yuan, such global developments can interrupt the game plan and complicate Fed guidance, whether by blue dot or tweet.

A third risk to the dot plot liftoff path is the composition of the Fed board. Chair Janet Yellen’s term expires in early 2018 (and Vice Chair Stanley Fischer’s term in mid-2018), and there are soon to be three vacancies on the Board of Governors. Whatever the plans for ROA, today’s Yellen Fed cannot bind a near-future Fed that could have a much different composition, either less or somewhat more hawkish.

So the Yellen Fed is removing accommodation, and markets so far are buying into the plan. But investors would do well to stay tuned as we learn more about the Fed’s plan for its balance sheet and the White House’s plan for the upcoming Fed vacancies. And don’t forget those international hot spots.

Summary

Think of the increases in the fed funds rate not as the beginning of an interest rate tightening cycle, but as the beginning of a process to remove a substantial amount of monetary policy accommodation.

This “removal of accommodation” cycle still has a ways to go. The real (inflation-adjusted) effective fed funds rate is still negative, and accommodative, and likely will remain so until the nominal rate reaches 2%. The Fed’s latest dot plot suggests that won’t happen until year-end 2018.

At least three challenges could complicate the Fed’s efforts to remove accommodation. First, crucial details on how the Fed will shrink its $4.5 trillion balance sheet remain unresolved. Second, policymakers face the ever-present threat of a financial, political or geopolitical event somewhere in the world that disrupts trade flows, risk appetite, financial markets and exchange rates. Third, the composition of the Fed Board of Governors is likely to change significantly by next year.